Ideology over facts

In its recent country assessment letter on Mauritius, the International Monetary Fund (IMF) writes about the need for a “through review of labour laws and regulations…simplifying the regulations that govern firms’ ability to terminate and redeploy workers.” This is nothing but an ideological statement as there is no evidence that laws that make firing costly result in unemployment. In fact, against conventional ideas, OECD countries that have high employment protection tend to enjoy high productivity levels, low unemployment and high growth rates.

It is often argued that labour market rigidities are responsible for high unemployment rates in Europe compared to the US. But this statement belies two important facts. Firstly, there is no single rate of unemployment in Europe: in 2002, it ranged from 2.6% in Switzerland to 11.5% in Spain. Secondly, the majority of European countries have lower unemployment rates than the US. Indeed, the higher European average is driven by high unemployment in large EU countries like France, Germany and Spain.

Nickell and Nunziata (2005) identify some sources of labour market rigidities:

1. the unemployment benefit system
2. the system of wage determination, that is, whether wages are determined by centralised (country-level) trade-union bargaining or decentralised (industry-level) bargaining
3. the degree of employment protection, that is, firing costs to firms
4. taxes on labour (such as mandatory social security contributions)
5. barriers to mobility (such as housing costs)

Here is what Belot and van Ours (2004) find in an interesting study of OECD countries:

“…there does not seem to be a one-to-one relationship between labor market institutions and labour market performance as some countries, usually classified as ‘rigid’, perform quite well.”

They find that some institutions/rigidities do cause unemployment:

“..the group of countries with a large increase in their unemployment rates since the early 1980s is characterized by a relatively high tax burden, Switzerland being the exception. The successful countries have a relatively low tax burden, with the exception of the Netherlands.”

Belot and van Ours (2004) measure firing costs or employment protection using three indicators:

1. protection of open-ended labour contracts
2. restrictions on the use of fixed-term contracts
3. restrictions on the use of temporary work agencies.

They conclude that “employment protection and centralization [of wage bargaining] have a negative influence on unemployment.” Put simply, making it easy for firms to lay off workers would, in fact, increase unemployment.

The intuition behind is clear: what matters is not whether a firm can lay off workers or not (there are so many other ways of subtly showing someone the door, like demoting), but whether the firm finds hiring attractive and this comes through low taxes, a buoyant economy and reasonable trade unions. The dynamism of hiring is more important than the dynamism of firing. Even better: if laying off is difficult, firms may an incentive to help their workers improve their skills. This may explain why countries with high employment protection tend to have higher productivity.

Millions went to the streets in France back in the Spring in protest against the Contrat de Première Embauche (CPE) which aimed at easing the firing of new workers. The same arguments were advanced by economists who opposed the law, which ultimately never came about. Now, I can almost hear people say that Mauritius is not an OECD country and therefore different rules apply. May be, but not in this case. Employees and firms do respond to incentives, pretty much the same way as everywhere else.